Insurance as a Cover Against Loss of Insurable Interest - Essay Example

?Conventional insurance and mutual or co-operative insurance Introduction Insurance is a cover against loss of insurable interest and hence a need for individuals and businesses to safeguard themselves by mitigating risks and losses so that catastrophic events have lesser impact on the life of individuals and their wealth. Financial institutions also resort to insurance cover for covering losses. When Islamic banking was introduced in 1970s, insurance also was sought to be brought under Islamic principles (Ayub, 2009). Conventional insurance is based on uncertainty and has some interest element both of which are against the Shariah principles. This paved way for the development of Takaful form of insurance that is Shariah compliant. Mutual risk arrangement Takaful envisages transfer of risk on mutual basis under which arrangement are the participants and operators. It is almost similar to conventional mutual risk sharing such as Mutual Insurance and Indemnity Club (P and I Club). The difference between Takaful and conventional insurances lies in the manner in which risk is managed and Takaful fund is operated. There are differences in relationships between the operator and participants who represent the insurer and insured respectively in the conventional insurance. The management of risk refers to the way risk is assessed (underwriting) and handled. Unlike conventional insurance, uncertainty, speculation (gambling) and interest elements are prohibited in Islamic life and the Takaful insurance is free from these vices known as Gharar (uncertainty), Maisir (gambling) and Riba (interest or usury). (Iqbal, 2005). In order to be free of Gharar, a Takaful contract must be subject to full disclosure from both sides so that there is complete clarity. The full disclosure or clarity should be in respect of the subject matter and terms of contract. If there is any unknown element or unknown exposure, Takaful contract cannot be entered into. But since this ideal situation does not always exist, Takaful contract ensures that there is at least no exchange of Gharar among the parties to the contract (Iqbal, 2005). Prohibition of Maisir (gambling) that is an extreme form of Gharar does not allow risk transfer on speculative basis. Riba, another prohibited element, is avoided by treatment of contribution from the participants as part of risk sharing scheme and not as a premium in conventional insurance. In Takaful, the contribution is envisaged as Mushahamah in the form of donation with a condition of Tabarru (compensation). Further, under Takaful, the funds so collected should be managed and invested following Shariah principles (Iqbal, 2005). Islam does not prohibit risks as they are a reality. It only prohibits trading on risks. Islam does allow mutual help in any situation including when some misfortune strikes. Both the forms of insurance deal with risks but in a different manner from each other. Under conventional insurance, risks from various insured persons are transferred to the insurer by insured against exchange of premium collected by the insurer. On the other hand, under Takaful risks are shared by the participants (insured) by contribution to fund under a mutual guarantee scheme to be managed by Takaful operator Wakeel (agent). Thus, there is no risk transfer to the operator in Takaful insurance. The conventional insurance actually exchanges uncertainty for certainty. The uncertainty relates to whether or not loss will occur and if at all it occurs, when it will it occur and what will be severity of loss like and how many such losses are likely to occur within a given period. The conventional insurance envisages payment of fixed premium by the insured to insurance company who in turn will pay the loss if it ever occurs within ambit of policy terms. This exchange of uncertain loss is Gharar in Islam and hence not allowed. Therefore, the Takaful avoids risk transfer by the participants (insured) to the operator. This facilitates sharing of risks by among the participants under what can be called a mutual guarantee scheme. Takaful operator merely acts as their agent and ensures that they pay equitable contribution and also that those who suffer loss get the right amount of compensation (Iqbal, 2005). Risk management involves 1) recognition of risks, 2) ranking of risks, 3) controlling of risks, 4) responding to significant risk, 5) reaction planning, 6) risk management system and 7) risk assurance system. These elements of risk management applied in risk financing give rise to the areas of activity such as “evaluation of total values at risk, estimation of total cost of risk which consist of a) cost of retained losses, b) cost of risk sharing scheme under Takaful, c) risk control and handling costs and d) risk management and administration expenses, and identification of appropriate sources of funding in advance of any loss. One of the sources could be proceeds from a Takaful fund “ (Iqbal, 2005, p. 19). Takaful concept of risk financing aims at grouping of individuals and organisations whose risks have a homogenous pattern. The Takaful operator collects contribution or donation from them undertaking to pay them from the proceeds of Takaful funds for meeting their losses in the event of their risks materialising. In order to avoid Gharar, Maisir and Riba, Takaful adopts profit sharing contract (Mudharabah), Wakalah (agency contract) or any other suitable contract instead of a sales contract (Iqbal, 2005). It would now be clear that Takaful is a mutual insurance where the participants are the owners of the scheme. This involves pooling of risks whereby the person manages the scheme is a professional charging a fee for services instead of profit. The profit goes to shareholders from risk management and not risk taking. In case of deficit in the pool, strictly viewed, it is to be shared by the participants. But in order to spare them of the burden, Takaful gives solutions to enable them get their benefits instead while at the same ensuring Shariah compliance. Hence contract is based on Tabarru wherein Gharar is permitted and not on the basis of contract of compensation (Rahim & Wahab, 2006) Just as there are differences between the conventional and takaful models of insurance, there are differences among the various models of takaful insurance. The differences rather relate to the underwriting of risk portion and not in relation to non adherence of Islamic principles. Two major models are Mudaraba Model and Wakalah Model. Mudaraba model also known as Malaysian model. In this, contributions from participants and income from investments are used to meet claims, reinsurance/retakaful insurance costs and other claims related expenses. The surplus after meeting all these remaining in the takaful funds is shared between the participants and shareholders in 60:40 ratios. The shareholders are expected to meet their marketing and management costs from out of their 40% share of the surplus. This is not in harmony with Shariah since Mudaraba is a profit sharing contract whereas the investment comes in the form of donation (Tabarru) contract. This is an apparent incompatibility. Secondly, in Mudaraba contract, profit should be earned and distributed. But the Mudaraba form of Takaful envisages sharing of surplus i.e excess of premiums over claims, reserves and expenses. Thirdly, sharing of surplus in the written funds in this model is no different from conventional insurance. But in the latter, shareholders are risk takers. Hence essentially this model is rooted in risk taking not in mutual assistance. Fourthly, the arrangement of payment of Qard Hasnah (for deficit) is against the tenets of a Mudaraba concept since a Mudarib is not a guarantor. Lastly, the Mudaraba principle and Risk sharing principles are not compatible with each other (Rahim & Wahab, 2006). Wakalah Model While the above is popular in Malaysia, this model is followed in Middle Eastern countries. In this model, the operator of the Takaful model is the Wakeel for the participants. He is only entitled to a fee for managing the affairs. The fee ranging from 20 % to 35 % of the contributions is payable upfront. This fee is transferred to Shareholders’ account and balance to Takaful account for payment of claims and cost of retakaful. The balance is for payment to the participants. Mostly some amount out of this surplus is retained as a contingency reserve and balance paid to the participants in ratios proportionate to their contributions. In case of deficit, shareholders are required to give Qard Hasnah to the participants since recovery from the participants is not possible. Shariah concerns are in respect of charging of expenses and the fee structure. The charging of fee by the operator in a pure Wakalah model or sharing of underwriting surplus in a Wakalah variant model is not in keeping with the concept of mutual assistance. The risk premium disclosed is inclusive of expense and profit components and should be shown separately unlike in the conventional insurance where there is no need to show the break ups. This being a contract of mutual assistance, these components need to be disclosed. Further, the donation is a conditional gift envisaging payment of surplus to the participants. This gives rise to issues of inheritance and Zakat (Rahim & Wahab, 2006). Differences between conventional insurance and Islamic insurance The buy and sell form of conventional insurance is not the same as buy and sell under Shariah which abhors gharar, maisir and riba. In conventional form, there is lopsidedness resulting in advantage for one over the other. This is known as contractual injury that is against the doctrine of fairness (adl) and good virtue (eshan) of Shariah. Takaful incorporates the principles of joint help, cooperation, solidarity (joint guarantee). It envisages working together for common good through contribution/donation to serve the requirements of the needy, enjoyment of profit together and creation of defined fund for payment of defined loss. Reinsurance is a necessity (hajat) in the absence adequate Islamic reinsurance service (retakaful) (Yusof, 2008). In a nutshell, in conventional insurance which is non-mutual, premium is calculated that would cover claims and profit which is speculation akin to Maisir in Shariah. The insured pays premium in consideration of the insurer indemnifying the insured against risks that may or may not occur. This is an uncertain aspect which is Gharar in Islam and cannot be part of any activity. The insurer invests the premium so collected for interest and on the industries prohibited by Islam such as production or trading of alcohol or meat industry not allowed in Islam. So the interest and investing on prohibited industries are riba and haram respectively in Islam. On the other hand, Takaful is based on the concept of Ta-awum i.e mutual assistance that should voluntary (Tabarru). It is almost like conventional mutual insurance industry in which members pool their funds to insure one another. It is also a mutual guarantee This makes the policy holders both as insured and insurers. Takaful undertakes to pay a defined loss from a defined fund. The loss is met out of funds donated by the policyholders. The liability is spread over all the policy holders and losses and divided amongst them. By donating contributions, the policyholders become the owners of the funds and are eligible to participate in profits in proportion that would vary from one model to another. Takaful removes uncertainty by undertaking to pay from the fund loss incurred without being pre-determined (Ernst&Young, 2009). Comparison of Takaful, Cooperative Insurance and Conventional insurance Takaful is donation and mutual contract combined. Cooperative insurance is only a mutual contract. The conventional insurance is an exchange contract. In Takaful, company meets claims from the underwriting funds and for any shortfall, it provides interest free loan. In cooperative insurance, company meets claims from the underwriting fund. The conventional insurance envisages payment of claims by the company from the underwriting fund as well as shareholders’ funds. In the first two, participants pay contributions whereas in the last, participants pay premiums. Capital comes from the funds of the participants in Takaful while in cooperative insurance, it is from the participating capital.In the conventional insurance, capital comes from the shareholders who are not necessarily the insured. In the first one, investments should be Shariah compliant. There is no such restriction both in cooperative insurance and conventional insurance except they must meet the prudential norms (Ernst&Young, 2009). One distinct feature of Takaful is that it forgives Al Gharar by resorting to Tabarru’. In Takaful, all cooperative insurance concepts are present where as cooperative insurance is not necessarily based on Islamic principles (Taylor, 2008) The operational difference between conventional insurance and takaful being followed Syarikat Takaful Malaysia relates to investment of the assets and treatment of expenses and surplus. Investments are made in halal assets only. As for expenses, all the management expense is chargeable to the operator’s fund. The direct expenses such as medical underwriting fees are charged to participants’ fund. For the labour provided by the operator in setting up and managing the takaful operation, he is given a share of profit on investment which is defined as the income earned on assets invested. He can also have a share in the surplus arising from underwriting business. The underlying contract is takaful is Mudaraba. In Mudaraba there is a capital provider and services provider, the participant and operator respectively. There is no governmental regulation Islamic insurance. It is left to the discretion of the operator and the Shariah advisory board. This had led to four companies with takaful having divergent views on takaful implementation. Because of this, regulators are not sure of how takaful contracts must be regulated. On the other hand conventional insurance available alongside is regulated by the Insurance Act in Malaysia and they are not permitted to deal with takaful products (Jaffer, 2005). Conclusion The above comparison of the takaful with conventional insurance highlights the most important differences arising out of Gharar, Maisir and Riba principles. Though the takaful industry has no significant market share, it is rapidly growing and even non-Muslim countries patronise takaful for its qualities. In both the cases, risk is spread out so that there is equitable distribution of premium burden on the participants/insured. The profit element alone is missing in takaful but it is circumvented by the fees to the operator. Operator cannot be treated as an employee. There must be an element of enterprise with some benefit akin to profit is necessary for any venture to be successful. Takaful cannot be an exception to this. Just as takaful is regulated by Shariah principles, conventional insurance is regulated by Insurance Acts and regulatory bodies who prescribe prudential norms. Hence, conventional insurers cannot be profiteering as they please and they are also subject to certain ethical norms and ethical conduct. These features probably can be cited as similarity between the two. If halal investments alone is permitted under conventional insurance and interest is also prohibited for late payments and loans taken under the policies, then there is not much of a difference between the two except in respect of Gharar. References Ayub, M. (2009). Understanding Islamic Finance. Jonn Wiley and Sons . Ernst&Young. (2009). The World Takaful Report 2009 Opportunities in adversity-the future of Takaful. Ernst & Young's Islamic Finace Services Group. Iqbal, M. (2005). General takaful practice:technical approach to elimiate Gharar . Jakarta: Gema Insant. Jaffer, S. (2005). Islamic retail banking and finance: global challenges and opportunities. London: Euromoney Books . Rahim, A., & Wahab, A. (2006). Takaful Business Models- Wakalah based on WAQF: Actuarial Concerns and Proposed Solutions . Presented at Second International Sympsoium on Takaful 2006 Malaysia. Taylor, D. Y. (2008). Developing a Family Takaful Operation in the Kingdom of Saudi Arabia. Bank of Aljazira's Takaful Ta'awuni- a Modern Day Success Story 2nd International Takaful Summit London July 15th 2008. Yusof, D. F. (2008). The Basic Concept (s) of Takaful (Session 1- The Essence of Takaful). 2nd Takaful Summit "Matercalss" Lovells LLP, London. 14th July 2008. Read More